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New research from the Federal Reserve Bank of New York finds that the largest global banks – those perceived as being ”too big to fail” – enjoy a funding advantage that allows them to get loans more cheaply than their smaller competitors. Even more disturbing, this advantage seems to lead them to engage in more risky behavior, as measured by impaired and charged off loans.

Some have challenged these findings, by claiming that large non-financial firms also have lower borrowing costs than smaller firms; in other words, the argument goes, the funding advantage is not due to the ”too big to fail” perception of potential government support. But Santos’ research finds that large banks have a borrowing-cost advantage significantly greater than any advantage of large firms in other industries. As he states, his results “suggest that the cost advantage that the largest banks enjoy in the bond market relative to their smaller peers is unique to banks.”

In further research, Santos and coauthors Garo Afonso and James Traina find that the perception of ”too big to fail” status and an accompanying potential for government support appears to lead banks to engage in more risky behavior. Banks classified by ratings agencies as likely to receive government support have greater loan losses and a higher percentage of impaired loans, the paper finds, than do institutions that are not so classified. This suggests that banks take advantage of the implicit expectation of taxpayer support in the event of losses by pursuing higher profits through riskier lending. The possibility that losses from these loans could be transferred to the public leads to riskier bank behavior.

A leaked draft of the TBTF proposal being put together by Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) was evidently the cause of much mirth in big-bank circles. The proposal’s capital requirements were described as “comically high” by Rob Nichols of the Financial Services Forum, as quoted in Ben White’s Morning Money column on Politico.

But Tuesday’s column brought forth replies from a number of unamused observers. “The largest financial organizations contributed to the financial crisis because they were so poorly capitalized,” FDIC Vice Chair Thomas M. Hoenig commented. “Ask the eight million people who lost their jobs during the crisis how comical they think higher capital requirements are.”

Camden Fine of the Independent Community Bankers Association offered a riff on “John Kerry’s famous line: ‘They voted against [the Dodd-Frank Act] before they voted for it,” adding, “And that is really ‘comical’.”

AFR had this to say: “It’s not surprising that the Financial Services Roundtable would try to belittle the Brown/Vitter draft requiring additional capital, since it’s a lot more profitable for banks to get implicit backing from taxpayers than to raise their own capital from the private sector. But they shouldn’t be able to get away with the myth that additional capital would constrain bank lending.

“Capital requirements don’t place any restriction on the amount of lending banks can do. They simply require that this lending be funded by private sector risk capital so that taxpayers aren’t on the line if banks take losses. Especially since the Brown-Vitter proposal would give banks a full five years to raise the added capital, it makes no sense to argue that banks wouldn’t be able to lend. And the minimum capital levels in the draft are hardly ‘comical’ — they are in the ballpark of capital levels called for by experts like Sheila Bair, and below levels typically held by banks before the creation of the public safety net.”

“Wall Street’s bragging about having ‘record high’ equity ignores that it is still way too low to avoid another financial collapse or massive taxpayer bailouts,” said Dennis Kelleher of Better Markets.

In the flurry of amendments to last week’s budget bill, the Senate voted by the remarkable tally of 99-0 for a “Too Big to Fail” proposal sponsored by the bipartisan trio of Sherrod Brown (D-Ohio), Bob Corker (R-Tenn.), and David Vitter (R-La.). Their amendment calls for steps to analyze and end the huge public subsidy that benefits the six largest banks – those with $500 billion or more in assets. Although the amendment is nonbinding, its overwhelming approval suggests growing support for action to end the era of taxpayer-subsidized megabanks.

Recent studies have put the ongoing funding subsidy to TBTF banks at $80-$100 billion a year. According to a Bloomberg analysis, JPMorgan, Bank of America, Citi, Wells Fargo, and Goldman Sachs account for $64 billion of total subsidy – “an amount roughly equal to their annual profits,” as Bloomberg points out. See AFR statement of support for Vitter-Brown-Corker.

“We’ve seen how too-big-to-fail is also too big to manage, too big to regulate, and too big to jail,” Senator Brown said in a statement issued before last week’s vote.

“This is a really impressive sign that we mean business on ending too-big-to-fail,” Senator Vitter declared afterward.

Vitter and Brown are working on the next step: legislation to require the megabanks to downsize, or face significantly higher capital and other requirements.

In a moment of striking candor last week, Attorney General Eric Holder came close to agreeing that major banks have become “too big to jail.”

“I am concerned,” Holder told the Senate Judiciary Committee in answer to a question about the failure to bring criminal charges against HSBC and other banks, “that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them…” Awareness of the potential “negative impact on the national economy, perhaps even the world economy” can have an “inhibiting impact on our ability to bring resolutions that I think would be more appropriate,” he explained.

In other words, the awesome size and power of the biggest banks threatens not only the economy, but also the rule of law. While that is obviously an unacceptable attitude for top officials of the Justice Department – and an attitude they had better rethink – it reinforces the case for downsizing these institutions.

It also reminds us that financial regulation cannot be effectively reformed until we address the question of bank scale and complexity. If the government balks at the idea of punishing a bank implicated, as HSBC was, in money-laundering for drug lords and terrorists, it seems certain that banks will not be held accountable for violating technical rules on risk management. In short, no regulations will work as long as the biggest banks can count on more of this soft-gloves treatment.

If the Justice Department is stymied by fear of the economic repercussions, “That’s a very scary, very ugly way to run the country,” Halah Touryalai wrote on Forbes.com. adding: “It’s no wonder then that big banks hate the idea of breaking up.”

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This blog is maintained by AFR as a forum for ongoing news and commentary about the fight for effective financial reform. Blog posts represent the opinions of their authors / posters, and do not necessarily represent the views of the AFR coalition or coalition members.